Rising Junk-Bond Liquidity Concerns

August 6, 2014

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According to a Barclays PLC index, U.S. funds investing in
debt rated below investment grade lost an average 1.33% in July, their
second-worst monthly performance since November 2011. In June 2013, after the
Federal Reserve began hinting that it would scale back its monetary easing,
they lost 2.62%. The latest junk-bond decline intensified last week as
investors continued to make heavy withdrawals of money, in part because of
worry that could prompt the Fed to raise interest rates sooner than expected, a
move that would likely pressure bond prices.

Reflecting the cautious mind set, some portfolio managers
are selling riskier bonds and replacing them with safer ones because of concern
about market liquidity. Many investors say liquidity is drying up as the Fed
pares its monthly stimulus and large banks trim their bond inventories. Investors
pulled more than $5 billion in July from U.S. junk-bond mutual and exchange-traded
funds deepening the liquidity fears and adding to concern that the recent
selloff could intensify.

The downdraft in junk debt highlights concerns that
purchasers in the $1.6 trillion U.S. market, lured by higher income than on
government and highly rated corporate bonds, have paid too much for the
securities. Many investors say prices have rallied, sending yields to levels
too low to compensate buyers for the risk of the investments.

The tremors are being closely scrutinized across Wall
Street. Many investors this year have expressed concerns that a pullback in
junk-bond prices could signal that market participants are rethinking their
willingness to take risk, foreshadowing further declines in stocks and other
risky assets. The Dow Jones Industrial Average has dropped seven of the past
eight trading days and is down 0.5% this year.

Brian Connolly, co-founder of hedge fund Millstreet Capital
Management in Boston, which oversees more than $200 million in assets, recently
tried to sell $3 million of energy company bonds but couldn't find buyers for
three days which typically such a sale takes a day at the most.

Some investors have used the sales to bulk up on safer
securities such as higher-rated corporate bonds and U.S. Treasury debt, fueling
the latest rally in the ultrasafe bonds. The 10-year Treasury note on Friday
rose in price to yield 2.494%, down from 2.565% at the start of July.

The problem also presents itself when traders need to buy
bonds in a hurry. Some investors blame lower inventories at banks that in the
past held a lot of bonds to fill client orders. Lately, they have been
shrinking those stockpiles to meet tougher capital requirements and gird for an
interest-rate increase.

Dealer inventories of high-yield corporate bonds fell to
$4.8 billion in early July. That is the lowest level since April 2013, when the
Federal Reserve Bank of New York began publishing data for separate types of
debt, and down from $7.9 billion the previous week.

Signs are rife that trading is thinner. Just 1.8% of
outstanding U.S. bonds changed hands on an average day in the first quarter,
down from 2.2% a year ago and a 2002-2008 average of 3%, according to the
Securities Industry and Financial Markets Association.